Having fallen behind the curve on inflation and embarrassed itself by lecturing the market on the correct definition of transitory, the US Federal Reserve is now trying to sprint ahead again by signalling a faster and earlier reduction of its swollen balance sheet than bond-market participants had expected.
Released on Wednesday, the minutes of the December meeting of the Federal Open Market Committee (FOMC) show that almost all participants agreed it would be best to begin balance-sheet reduction soon after the first rise in interest rates – which some dealers expect as soon as March and that is fully priced in for May.
The bond markets are now pricing in three rate hikes this year, in line with the Fed’s own median dot path. Normally markets position for the Fed doing more or less than consensus. This unanimity is unusual. But it does not presage market calm: quite the reverse.
In the only previous episode of quantitative tightening, the Fed waited two years after the first rise in rates before running down its balance sheet from 2017. But this time its balance sheet is much bigger both in nominal terms and as a percentage of GDP, and has a much shorter average duration. Simply not re-investing maturing balances will inevitably lead to a faster run-off.
In addition to a larger balance sheet, the FOMC members note a stronger economic outlook and higher inflation that could warrant a faster pace of what it calls ‘balance-sheet normalization’.
Hat-tip to The Wall Street Journal, which managed to get an early view of the discussion: the minutes still caused a strong reaction, prolonging the sell-off in 10-year Treasuries, which have seen yields rise 20 basis points since the start of 2022, up to 1.73%.
Quite a tussle
This is a big move coming after the flight-to-safety rush into Treasuries pushed yields down as the Omicron variant emerged in December. The rise now comes as sovereign, supranational and agency issuers, as well as banks, all rush to borrow large amounts in the bond markets and front-load their annual funding programmes ahead of rate rises.
There is going to be quite a tussle in the weeks ahead as fund managers seek to extract higher new-issue premia, while issuers know they have large cash balances to invest.
Equity markets also sold off, led by the growth and technology stocks whose valuations most depend on the abnormally low discount rates that have prevailed in recent years.
What banks fear most is a sharp crash in financial markets and then a funk period when clients do nothing
Analysts have been predicting a volatile year for financial markets: that has kicked off in the first four days of trading in 2022. Even bitcoin sold off sharply after the Fed minutes came out.
The bulls are tempering their forecasts. The chief investment office of UBS Wealth Management notes that the equity sell-off comes after a recent rally to all-time highs, argues that the normalization of Fed policy shouldn’t dent the outlook for corporate profits and points out that equities can still do well in the months leading up to a first rate hike.
But it now prefers senior loans over Treasuries or investment-grade corporate bonds.
Markus Allenspach, head of fixed income research at Julius Baer, notes that while the yield on the 10-year Treasury rose to 1.73%, the 30-year hit 2.11%.
“The former is still markedly below our economists’ three-month target and fair value,” he says.
At the long end, a single basis-point move higher in yields can lead to a big drop in face value.
Vulnerabilities
Meanwhile, almost overlooked in analysts’ reading of the Fed minutes, several members of the FOMC expressed concerns about vulnerabilities in the US Treasury market.
The world’s biggest interest-rate market has suffered from a reduction in liquidity in recent years that could be exacerbated by a sharp sell-off, even though the Fed’s standing repo facility may give comfort to banks that they can at least turn Treasuries into cash if they need to.
In addition, FOMC members note much greater uncertainty about the impact of reduction in Fed balance-sheet size on the economy compared with the impact of rising rates.
If heightened secondary market volatility is almost guaranteed in 2022, that might benefit banks if it remains contained and investor turnover stays high. What banks fear most is a sharp crash in financial markets and then a funk period when clients do nothing.
And the outlook for primary markets is equally unclear. In 2021, global investment banking revenue hit $128 billion, up 39% on 2020, according to Dealogic. That strong total came after a 5% decline in revenue from debt capital markets that was far off-set by a 20% rise in US equity capital markets revenue, a 40% rise in European ECM revenue and a 64% rise in the smaller revenue stream from global M&A.
It remains to be seen how corporate executives and boards, now battle-hardened through two years of the pandemic, cope with the coming financial market falls.
